July 2012 Economic Outlook

July 10th, 2012

This is a monthly newsletter by Greg Sweeney, CFA, Chief Investment Officer, at Bell State Bank & Trust. Sweeney holds a bachelor’s degree in business from the University of North Dakota, is a CFA charter holder, and is a 25-year veteran of the Investment Management team.

Federal Reserve Monetary Policy

At the next Federal Reserve meeting on August 1, we expect the Fed to leave rates unchanged between zero and 0.25%. The Fed indicated rates would remain near these lows until late 2014.

Inflation

The year-over-year consumer price index (CPI) released in May shows inflation at 1.7%. The release in July is likely to show an equally low rate as the Bureau of Labor Statistics (BLS) calculates it. It is surprising rising rents don’t appear to be pushing inflation higher. The BLS is likely either considering them “transitory” or perhaps reducing housing’s weight in the index.

Economic Activity

On the day we were preparing this issue of Outlook, we learned that the Supreme Court upheld the healthcare law. Nobody knows what this means for future costs, but on the surface it looks as though they will be noticeably higher than any estimates to this point. Why? Because healthcare represents 18% of gross domestic product (GDP), yet it appears that the charge for health insurance will be limited to no more than 9.5% of income (for employers with 50+ employees). So what is the problem? GDP is the cumulative spending of individuals and government (with a couple of other minor factors). The ability for consumers and governments to spend is based on earnings. With $15 trillion GDP, 18% is $2.7 trillion in healthcare costs, while 9.5% of GDP collected in healthcare premiums is $1.425 trillion. The difference is $1.275 trillion. This gap is quite unsettling; we will either make it up in new taxes or have additional government deficits. Sure, there are lots of moving parts in the healthcare law that likely make this observation overly simplistic. Maybe it is not supposed to work in the first place. Is it just a step in the process of getting one big government-run healthcare program?

If Congress allows all the spending cuts to take effect, coupled with the complete elimination of tax cuts at the end of 2012, the confidence level for experiencing a shallow recession in 2013 increases. If politicians choose to extend and pretend, it will reduce the prospects of a recession by allowing time for improvement, but it comes at the expense of budget projections as we dig ourselves such a deep debt hole that even the Hubble telescope would have a hard time getting a good picture. Pay a little now for the sins of our past or pay a lot more later for the continuation of our neglect. This is the theme in Europe also. Spain and the small island state of Cyprus formally became the fourth and fifth countries to request aid from the Euro Zone’s bailout funds, extending a casualty list in a protracted regional debt crisis. Another summit is convening to devise plans to solve the debt problem. The half-life of the outcome from each meeting gets shorter each time. There are three ways out of debt: (1) pay it off, (2) default, or (3) inflate.

Enough of the gloomy data. Over the past year, we have mentioned the firming foundation of the housing market, which looks like it may be in a position to grow. Sales have stabilized, and prices are firming. Reducing the friction in underwriting and lending will go a long way toward boosting this sector.

Fixed Income

Treasury rates, at 60-year lows last month, are even lower now. The 10-year Treasury bond yield is now 1.58%. This is not very supportive for earning a real after-tax rate of return.

Stock Market

Analysts are starting to question their own earnings forecast in the face of current economic conditions. U.S. companies are starting to questions their own outlooks, too. That leaves investors with a bit of worry. Daily volatility has increased, but the range has been narrow so far.

The biggest influence aimed at pushing the stock market higher is the Fed. The headwinds might be stronger than the Fed at the present time, which may tip the scales toward more downward pressure than upward pressure.

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